Warren Buffett defends Berkshire's conglomerate structure — and fires a huge shot at private equity (BRKA, BRKB)
Berkshire Hathaway is a massive conglomerate.
With a market cap over $300 billion, the company directly owns dozens of businesses and holds huge stakes in many more, some of which include America's largest companies like Coca-Cola, IBM, Wells Fargo, and American Express.
In his 50th letter to Berkshire Hathaway shareholders, Buffett addresses this structure, which he says has a terrible reputation with investors, which it "richly deserves."
But of course, it could probably be worse: Berkshire could be a private-equity firm.
In his letter, Buffett writes that the bad reputation for conglomerates is mostly owing to the problems this structure had in the 1960s, when companies were acquiring any and all other businesses in an effort to boost per-share earnings. Eventually this scheme fell apart and the conglomerate structure — which often involved a holding company owning disparate businesses under one roof — became out of fashion.
But the conglomerate structure, Buffett argues, also gives the current iteration of Berkshire Hathaway a kind of flexibility for acquisitions that you can't get just anywhere. "To put the case simply: If the conglomerate is used judiciously, it is an ideal structure for maximizing long-term capital growth," Buffett writes.
And because Berkshire is a conglomerate, Buffett says the company doesn't have an affiliation to any particular business or line of work, with Buffett writing, "That’s important: If horses had controlled investment decisions, there would have been no auto industry."
This structure has also allowed Berkshire, in Buffett's estimation, to becomes the "home of choice for the owners and managers of many outstanding businesses."
"Families that own successful businesses have multiple options when they contemplate sale," Buffett writes. "Frequently, the best decision is to do nothing. There are worse things in life than having a prosperous business that one understands well. But sitting tight is seldom recommended by Wall Street. (Don’t ask the barber whether you need a haircut.)"
Buffett says that companies looking to sell are often then left with two types of buyers: competitors and private equity firms ("Wall Street buyers," Buffett calls them).
And it is the latter that can be most unpleasant.
For some years, these purchasers accurately called themselves "leveraged buyout firms." When that term got a bad name in the early 1990s – remember RJR and Barbarians at the Gate? – these buyers hastily relabeled themselves "private-equity."
The name may have changed but that was all: Equity is dramatically reduced and debt is piled on in virtually all private-equity purchases. Indeed, the amount that a private-equity purchaser offers to the seller is in part determined by the buyer assessing the maximum amount of debt that can be placed on the acquired company.
Later, if things go well and equity begins to build, leveraged buy-out shops will often seek to re-leverage with new borrowings. They then typically use part of the proceeds to pay a huge dividend that drives equity sharply downward, sometimes even to a negative figure.
In truth, "equity" is a dirty word for many private-equity buyers; what they love is debt. And, because debt is currently so inexpensive, these buyers can frequently pay top dollar. Later, the business will be resold, often to another leveraged buyer. In effect, the business becomes a piece of merchandise.
Berkshire offers a third choice to the business owner who wishes to sell: a permanent home, in which the company’s people and culture will be retained (though, occasionally, management changes will be needed). Beyond that, any business we acquire dramatically increases its financial strength and ability to grow. Its days of dealing with banks and Wall Street analysts are also forever ended.
Some sellers don’t care about these matters. But, when sellers do, Berkshire does not have a lot of competition.
To Buffett, Berkshire offers a third, more friendly choice for sellers.
In 2014, Berkshire contracted for 31 "bolt-on" acquisitions worth $7.8 billion in all. The company also closed on its acquisition of Van Tuyl Automotive, which has $9 billion in annual sales and brings Berkshire's ownership of companies that would be independently listed in the Fortune 500 to 9.5 (Heinz is the 0.5).
And the company seems ready to find more things to buy. As Buffett writes: "Our lines are out."
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